Though It Hurts, Bruce Berkowitz Is No Bill Miller

There are a lot of analogies in the media these days to compare Fairholme Fund’s Bruce Berkowitz with Legg Mason Value Trust’s Bill Miller, as Berkowitz’s Fairholme Fund suffered its worst year of performance after years of tremendous outperformance. Many articles are predicting that Bruce Berkowitz is the next Bill Miller. Investors certainly treated Bruce Berkowitz the same way they treated Bill Miller. At the peak of Miller’s fame, after he had beaten the market average S&P 500 by 15 consecutive years, the size of his fund reached $20 billion in 2006. He suffered a 6.66% loss in 2007, while the market advanced in 2007, and a 55% loss in the market crash of 2008. Investors fled out of his fund. As of July 31, 2011, the fund has only $3.3 billion left, about 16% of the assets under management at its peak.

Similar things are happening to Berkowitz. With his outstanding performance, Fairholme Fund’s assets grew from $65 million in 2003 to $1 billion in 2005, $10 billion in 2008, and $20 billion on Feb. 28, 2011. However, investors quickly pulled out of his fund after just nine months of an ill-fated bet with financials. The fund has only $8.9 billion left now, according to Morningstar.

We estimate that his average cost per share with AIG (NYSE:AIG) is $33. At the current price he is losing about 30%. The bigger hole is with Bank of America (NYSE:BAC), in which Berkowitz is very confident. This is his holding history with Bank of America:

Fairholme’s cost per share is about $15, according to our estimate. Currently Bank of America is traded at around $6, implying a loss of 60%. If financials recover, it is relatively easy for AIG to climb 50% back to $33 a share. But it seems much harder for Bank of America to climb 150% back to $15 a share.

Regardless, the investors who rushed in Fairholme last year and pulled out this year have lost money, permanently. Talking about chasing hot funds…

We don’t think so, because they invest in fundamentally different ways. These differences lie in many aspects:

1. Miller is always fully invested; Berkowitz always tries to hold a large percentage of his portfolio in cash. Throughout the history of Legg Mason Value Trust, the fund is always 100% invested, regardless of market valuations. Berkowitz always tries to have 20% - 30% of his portfolio in cash, waiting for better opportunities, although the recent redemption has left Fairholme Fund fully invested.

2. Miller is always bullish; Berkowitz does not comment much on overall market. Over the years at GuruFocus we have never seen even once from Bill Miller that the market is overvalued. To him the market is always undervalued. Many times he uses simple market P/E ratio to prove that the market is undervalued. The market P/E ratio obviously has its flaws.

3. Bill Miller’s record 15 years of consecutive market-beating performance was built largely during the secular bull market started in 1990. In that bull market, being always fully invested and taking excessive risks made outperformance easier. The first bear market starting from 2000-2002 did not kill his performance. The second one in 2008 did, very badly. Berkowitz’s record was built on a secular bear market. Only a few months after starting Fairholme Fund, Bruce Berkowitz met his first bear market. He then had the second bear market in 2008. Both times he did well, and grew the net asset value of his fund by 300% in 10 years. Even with the recent decline, Fairholme’s net asset value is still more than 100% higher than its value at the beginning of 2000, while Legg Mason Value Trust’s net asset value is about half of what it was at the beginning of 2000.

4. The last aspect we want to point out is probably the most important of all. Miller’s portfolio carries far more risks than Bruce Berkowitz’s. Long before Miller’s market-beating streak ended in 2005, he already had many fatalities in which he had total loss, including losses in the two most infamous bankruptcies of Enron and WorldCom in the first recession of the 2000s. He continued to double down in his positions. His bets on Amazon (NASDAQ:AMZN) and Nextel, etc., saved his streak. He tried the same in the 2008 market crash. He had positions in almost every one of the large fatalities including Lehman, BearSterns, Washington Mutual, Fannie Mae, Freddie Mac, AIG, etc. This time he was not as lucky. His fund lost a whopping 55% in 2008.

On the other hand, over the years since we started to track Berkowitz, he never had one position that suffered permanent loss of capital. He never had one company that went bankrupt and wiped investors out. The same can be said to Warren Buffett.

Will Bill Miller ever restore his winning streak again? Very unlikely considering the market is still far too overvalued for another secular bull market. Will Bruce Berkowitz’s “all-in” bet on financials work out five years from now? We don’t know, but we won’t bet against it.

Comments

I agree with your premise. Bill Miller never struck me as a value investor. His purchase of Amazon is an example of his willingness to invest in overvalued securities. He was able to perform well throughout the tech bubble, but eventually his inability to focus on downside risk and a sufficient margin of safety severely damaged his long-term record.

I think Bruce Berkowitz will eventually bounce back. His thesis regarding financials makes sense from a value investor's perspective. For many of the big banks, reserves are plentiful, balance sheets are as strong as ever, loan delinquencies are improving, and valuations are extremely low.

My only issue with Mr. Berkowitz is why invest all your assets in financials when balance sheets for many large cap, high quality stocks are less levered and their valuations may be as attractive as the big banks?

Why not allocate 25% to stocks like BAC, C, GS, and AIG, and use the remainder of the portfolio to take advantage of low valuations in the tech sector, such as with Microsoft, Intel, and Cisco? Unfortunately, Mr. Berkowitz was forced to sell Cisco.

What you said about Fairholme never investing in a company that went belly up and becoming a source of permanent loss is in agreement with Berkowitz's investing process i.e. he hires advisors not to agree with him but to show how his investment idea could be wrong and as he says if the company can not be "killed " only then will he invest in it.

Also Berkowitz doesn't switch horses in the middle of the race. He has the courage of his convctions. Other investors that made similar bets caved in when things went against them and bailed, Berkowitz doubled down. You could say this was foolhardy, but so much depends on your time horizon. I ,for one. like the way he thinks.

There has been much said about his involvement in St. Joe and most of it negative. I think it will become one of his most successful investments. Why? Because he will make it so. As he has said, St. Joe is an asset management company with permanent capital. Look at other asset management companies( Luk, Bam). St. Joe will grow and evolve.

The Fairholme fund, if investors will stay and I think a core of them will, in the future can not be looked upon as your typical stock mutual fund even if it's defining characteristic is a concentrated portfolio. I think it will have more characteristcs of a hedge fund.

You could ask the question then why didn't Berkowitz start a hedge fund instead. Considering Berkowitz's background I think he wants to make money for the little man and not the big money types. But what ever comes out of the Fairholme fund it will not be the status quo. Berkowitz has too much intensity for that.

Maybe Berkowitz went all in on financials because 1) they are in his circle of competence and techs are not, and 2) financials look cheaper to him. He studied insurance and banks at least twenty years back and invested in WFC following the SNL crisis in 1990/1991, at the same time that Warren Buffett started buying WFC shares. I think he made the call independently. And I believe he will do all right.

Very true. Financials are well within his "circle of competence." The OID article from 1992 is fascinating.

I only mentioned technology because Mr. Berkowitz initiated a position in Cisco during Q2 of this year. Presumably, he was forced to sell to meet redemptions at a price well below his estimate of intrinsic value.

The short-term nature of many investors is very troubling, as selling is often detrimental to their wealth long-term. But value investing is not only about return, but also risk. Adding "blue chip techs," such as Cisco and Microsoft, may have provided better dollar weighted returns for Fairholme.

From Mr. Berkowitz's explanations, it appears securities such as Citigroup and AIG are 50-60% undervalued. He believes Citigroup has roughly $6 in earnings power per share, which would give the firm a fair value of $60-70 per share at a normal multiple for banks (10-12x earnings) when its full earnings power is realized. He believes AIG will earn $6 per share, giving it a fair value of roughly $70 in his mind (based on a multiple of 12x, a reasonable multiple for an insurance company based on history). He believes Bank of America has at least $2 in earnings power per share, which would suggest a fair value of $20-25 per share.

But you could also make the case Microsoft, Cisco, and Intel were 50% undervalued at their recent lows. Just as one can make the case for AIG at $70, Citigroup at $60-70, and Bank of America at $20-25, one can also make the case for Microsoft at $45-50, Cisco at $25-30, and Intel at $32-38. Many blue chip techs with competitive advantages and attractive margins were, at a point, selling for high single digit multiples after accounting for net tax adjusted cash.

Bruce all out bet on financials is quite bold. I have a feeling that the upturn in financials in 2010 which caused FAIRX to do very well then has a role to play in his big bet.

When I read the following in 2010 report I was concerned, but I unfortunately ignored my concern then. I am wondering if this affected his buying decisions. Investment thesis based on Govt doing its job.

"Over the past few years, Fairholme’s performance is due in large part to thousands

of patriots in civil service who rescued the global financial system with much intelligence

and hard work, demonstrating government at its best during a time of national crisis.

On behalf of nearly 500,000 shareholders and clients, Semper Fi.

Charlie Fernandez and I remain grateful for the many professionals that directly and

indirectly worked for our shareholders, with special thanks to the U.S. Treasury for

equitable treatment at AIG, to Goldman Sachs for outstanding advice in Asia and to

Great point about his "kiss on the cheek to the government" statement. I remember that very well and came away thinking the exact same thing. It was like he was sucking up to the bureaucrats or something. I thought it a foolish premise but didn't move my money at the time. It wasn't too long after that that the government threw him a major league curve ball and started selling their AIG stock. Go figure.

Time will tell whether he's right or wrong but it is certainly a gamble with big risks considering the very uncertain macro picture. That's why I'm just more comfortable with Prem Watsa and his "protect the money" position. If this is 1 in a 100 year event like Watsa thinks, I'm not sure what happens to the financials.

I agree the situations are very different between the two. To me Miller was reckless and presumptuous just prior to the crash in casually assuming Washington would not allow financials to fail and fall. Someone once said his general investing attitude was that the markets were either going up or going up alot!

Berkowitz, on the other hand, is rigorous, focused and intense, digging deep and (as mentioned) wanting to know every possible way something could fail. I believe Fairholme will come thru in the end. Financials are priced for an unlikely Armageddon.

On holding cash, however, Berkowitz confessed in the recent Wealthtrack interview that his cash level is now very low, at "mid-single digits". As to why, he said that at some point a value investor needs to have the courage of his convictions and go all in when he believes the moment is right.

I agree with Matt that there are now a lot of stocks on sale since August. Berkowitz and his shareholders would have experienced less quotational losses had he diversified into other sectors or held way more cash. That said, if I were in his position, I could see myself doing the same thing: backing up the truck when you see a great bargain. As Buffett said, the confidence you have in the investment and certainty of the business prospects are a significant source of margin of safety (Grep Speicher has a great post on that; see here http://gregspeicher.com/?p=3540#comments). So I find it difficult to blame him.

Were there misjudgments on his part? Probably. He may have overestimated the stickiness of his fund shareholders when it's well known that investors chase performance and are not likely to stick around when you go through a tough time. Now he has to deal with the cash cushion. Did he overestimate the earning power of the financials? I doubt it. But the bumpiness of the road to normalized earning power may have been a surprise. But macro events are notoriously difficult to predict. However, understanding the underlying business is the job of the investor, and on that front, I think Berkowitz has done a good job.

A decade or more ago I read that Japan's fund management business had shrunk by a whopping 95% in the 1990s. With figures like that one can understand Prem Watsa's concern that unpredictable events could arise following the last 'bubble'. I'm guessing that both Miller and Berkowitz will find that the mutual fund / investment fund structure and the ease of panicked redemptions will distract them and all other funds from making intelligent investment choices. They are ultimately at the mercy of fear mongering politicians and manic depressive media personalities.

The bank stocks are NOT priced for a bank system collapse. They are priced for another taxpayer-forced bailout--which is a growing possibility if you believe that the current crash in Prime RMBS valuations reflect the combined wisdom of the smartest credit investors in the world. I don't think Berkowitz, Miller, or any other speculators on bank stocks currently are really considering the risks. They've never been through the type of economic Depression/Recession environment currently being experienced. Even Buffett wasn't an adult during the Great Depression.

Considering the macro-environment, current stock market valuations, including the hobbled banking sector, are not inexpensive relative to historical valuations--unless your view of history spans only the inflated valuations occurring in the time period in the post-Ronald Reagan era.

If interest rates were normal (not depressed by taxpayer-forced subsidies via the Fed Reserve), we'd have a better approximation of the REAL valuations the broader stock market would support. I suspect that number would be at least 20% lower than current values. Frankly if 10-year government bonds were paying 5%, the broader stock market currently would have little to offer investors after adjusting for risk. Never forget that stock prices currently reflect a huge premium due to the government taking money out of the pocket of savers/retirees and using it to encourage speculation in risk assets.

Nearly all readers here seem to be frothing at the idea of a bottoming of bank stock prices. This reminds me of the investors in large drug companies several years ago, when stocks like Pfizer were sporting low valuations relative to their 10-year histories. Unfortunately, the drug stocks have been value traps, persistently bouncing around a channel with low valuations being the new normal. Like large drug companies, bank stock fundamentals explain the low valuations. Large drug companies have been facing (and will continue to face) expiring patents, mediocre pipelines, and increased government regulation. The large banks favored by the "guru" stock hucksters have their own set of headwinds that will suppress valuations for many, many years. This isn't 1993 for the bank stocks. It's more like 1933. The banksters will face a decade of housing/mortgage issues, tightened regulations, a new normal era of weak domestic consumers. Like the drug companies, bank stocks will bounce around a channel with low valuations. Banks are not like technology stocks that can have huge shifts in fortune independent of the economy.

I disagree with your comment re: Pfizer. Price to cash flow is the best way to value Pfizer as they have higher non-cash expenses than cap ex, mainly due to amortization of intangible assets. Pfizer's Price to cash flow was 11 or above until the credit crisis hit in 2008. It is now at a historic low of 6.5. Pfizer will be able to generate roughly $20 billion in free cash flow after synergies from the Wyeth acquisition are in full effect and cuts to ineffective R & D are completed. This incorporates patent losses from Lipitor and Effexor and is simply projecting cash flows from their existing pipeline. Now is about the best time to buy Pfizer for the long-term based on its price to cash flow ratio, as well as future improvements to free cash flow due to the cost cutting I mentioned above.

I can't believe that any "brilliant" investor would have a large chunk of his portfolio exposed to Bank of America at this point. BAC is a speculation rather than an investment. The company is a black box of legal liabilities. It has a long history of marginal management, with a legion of problems resulting from its reputation as a reckless, overpaying serial acquirer.

It should be in the same history book along with Washington Mutual, Bear, and Lehman, but thanks to the forced help from US taxpayers has managed to survive for the time being. Will Bank of America survive if their legal battles take a dramatic turn for the worse? Or if next year we go into another deep recession with a 20% leg down in commercial/residential real estate values?

With Fernandez leaving I think it is reasonable to guess there are some serious issues at Fairholme that are not a short term problem. This "all-in" with the finance sector will be one for the financial history books.

Bruce began his fund with about $10 million and peaked with $20 billion. It is similar to the tech stock boom; his reputation far exceeded anything reasonable.

>> My only issue with Mr. Berkowitz is why invest all your assets in financials when balance sheets for many large cap, high quality stocks are less levered and their valuations may be as attractive as the big banks?

Despite my comments here I do think Bruce will do well- but only if somehow he can pull himself away from hoopla-doopla and think. He pushed his long hair cool dude Abbey Road look about as far as stupidly possible. The issue for me is just as John Bogle suggests- that the star manager game is a poor choice for investors. At some point the mutual fund industry/managed funds industry itself should be held accountable for the fact that not only does it drastically underperform - investors only get a small fraction of their performance.

School teachers get blamed for students performance even when those students do not make an effort to succeed. Financial services people get a free ride.

It would seem that anybody with an IQ here would stop equating Warren Buffett's preferred investment with an outright stock purchase of Bank of America. Those kinds of posts belong on the stupid sites not this one.

Years ago Cramer or someone complained about some so called "value" funds like bill miller's buying high pe shares. I finally found millers rebuttal letter!

Bill miller wrote : (note, paragraph breaks may not be correct).

"Of course, in 1996, when we were buying Dell at $4.00 and trading at 6x with a 40% return on capital, no one thought we were being heretical. And when we were loading up on AOL at $15 in late 1996, people just thought we were nuts to buy something that was probably going out of business due to either the Internet, or Microsoft, or their own incompetence.

The issue of course is how can they be value now, with p/e's and p/book in the stratosphere?

Part of the answer has to do with general investment strategy. With money managers turning their portfolios north of 100 percent per year in a frenetic chase to find something that works, our glacial 11% turnover is anomalous. Finding good businesses at cheap prices, taking a big position, and then holding for years used to be sensible investing.

In a speculative market, long-term investing is rare, but it's what we do. We see no reason to sell a good business just because the stock price has gone up a lot, or because some amount of time has passed.

The better answer is that price and value are two different and independent variables. As Buffett has pointed out, there is no theoretical difference between value and growth; the value of any investment is the present value of the future cash flows of the business.

Value and growth do not carve the world at the joints; the terms are mainly used by consultants to allow them to carve the world of money managers up for clients. They represent characteristics of stocks, not of businesses. As Charlie Munger once said, the distinction is "twaddle."

With the market beating 91% of surviving managers since the beginning of 1982, it looks pretty efficient to me. Since a computer is not a scarce resource, and databases are not in short supply, accounting-based stock factors (price/earnings, price/book, price/cash flow, etc.) that the computer can identify and back test are unlikely to lead to robust performance.

Any combination of stock factors that appear to hold the key to outperformance will be quickly arbitraged away. There is no algorithmic way to outperform.

Any portfolio that outperforms over any length of time does so because it contains mispriced securities. The market was wrong about the future of that aggregate. We look directly for mispricings by comparing what the market says a company is worth with what we believe it is worth using a multifactor methodology.

This methodology starts with the accounting-based stuff and moves through private market value analysis, leveraged buyout analysis, looking at liquidating value, and of course involves a discounted cash flow model.

Valuation is a dynamic not a static process. When we first valued AOL it was trading in the mid-teens; we believed the business was worth $30 or so. We now value the business at $110 on the low end to $175, based on what we think is a conservative discounted cash flow. If we are right about the long-term economic model, the number could be much higher.

No one complains when we're loaded with General Motors or Chase—good, old, easy-to-understand values—or when we're buying perpetual dogs like Toys "R" Us or Western Digital in the midst of massive losses. It's the Dells and AOLs people object to. And what they seem to object to most is that we didn't sell Dell at $8 like other value guys did because historically PC stocks traded between 6 and 12x earnings, so when Dell hit 12x it must no longer be a value.

We are delighted when people use simple-minded, accounting-based metrics and then align them on a linear scale and then use that to make buy-and-sell decisions. It's much easier than actually doing the work to figure out what the business is worth, and it enables us to generate better results for our clients by doing more thorough analysis.

We own GM and AOL for the same reason: The market is wrong about the price because both companies trade at discounts to the intrinsic value of the underlying business."

"a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase." - Warren Buffett

"...a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield... such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something

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